Standard Life Investment’s James McCann, UK/Europe Economist looks at the challenges facing the UK as it bids to solve its productivity puzzle.

At first glance, people might wonder why the UK needs to prioritise structural reforms. It stands in a very respectable 7th place on the World Bank’s ease of doing business ranking and 10th on the World Economic Forum’s global competitiveness index.

In particular, the UK seems to score highly from an international standpoint with regards to the flexibility of its labour market. This has certainly helped over recent years, with the labour market showing few structural scars following the financial crisis. However, when we delve a little deeper, it becomes clear that not all is well with regards to the supply-side in the UK. Productivity has stagnated over recent years, with current output per hour at the same level as at the end of 2007.

Many countries have also experienced a sharp deterioration in productivity growth over the same period (see Chart 4). However, if we compare absolute productivity, the UK economy lags behind many of its developed world peers, with output per hour worked around 10% lower than the G7 average. Some of this shortfall is likely to be cyclical and we anticipate an improvement in productivity growth over coming years. However, it is hard to avoid the conclusion that a large portion of the weakness in productivity is structural and will require proactive policy action to repair.

The first step is to diagnose where these efforts should be directed. A closer investigation reveals that while the UK has a number of areas of strength, it does suffer from a number of shortcomings, particularly in its education system, infrastructure and planning system. OECD data show that England and Northern Ireland are in the bottom four countries for literacy and numeracy skills among 16-24 year olds.

The OECD also highlights the wide dispersion in attainment across students. To its credit, the government’s productivity plan acknowledges these shortcomings and has set out a programme of school reform, apprenticeships and increased professional education. However, it is relying on businesses to fund these apprenticeships and it should be noted that international evidence suggests that the returns from early-age education spending are highest.

The government is also cognisant of infrastructure issues, with the UK ranked 30th for the quality of its road network by the World Bank – behind Namibia. It has set up a National Infrastructure Commission, but has yet to commit the necessary funding required to significantly improve infrastructure, with fiscal policy still tight. Finally, the productivity plan highlights the undersupply of UK housing (see Chart 5), putting the blame squarely on planning restrictions. It has already tried to ease the planning process in the previous parliament but this has yet to translate into a sufficient pick-up in housing completions.

The good news is that the current government seems to be well aware of the UK’s structural challenges. However, it remains to be seen if the actions it is taking will be sufficient to drive a material improvement. In particular, its unwillingness to spend money on addressing some of these issues against a backdrop of fiscal austerity makes us less confident that the productivity plan will work. If the government cannot find the necessary funding to address these issues within its current fiscal plans, it should look to relax the pace of consolidation to accommodate these long-term growth-boosting policies.